View from the US: why small-medium sized businesses are using alternative lenders

blog_02_bigbanks View from Kabbage in the US - Kabbage has funded over $550 million to help businesses grow in the US. 

Many Big Banks are Still Slow to Lend

Even though the economy is improving and small business owners are more likely to apply for loans, there is a big lag between the growing demand for small business loans and the reluctance of big banks to actually issue those loans. Ted Zoller, director of the Center for Entrepreneurial Studies at the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill, states in, “A Look at the Future of Small-Business Financing,”that although loan demand is increasing, big banks are still recovering from the financial crisis. And that’s not the only thing holding them back; new regulations prohibit many banks from issuing as many small business loans as they used to.

“Across the board, bankers are seeing a rebound in credit applications for small-business loans,” Zoller says. “But the paradox is that banks are not in the position to fill that need to the extent they have been in the past. Regrettably, most of the capital available for debt is with large institutional banks that were significantly impacted by the financial crisis and now face substantial regulatory hurdles in determining creditworthiness for loans.”

Large Business Loans Have Recovered Faster

The news about bank lending is not all bad. A study from the Federal Reserve Bank of Cleveland, “Good News and Bad News on Small Business Lending in 2014,” found that bank lending to large businesses (loan amounts greater than $1 million) has reached a level 24 percent higher than it was before the recession. However, that same Federal Reserve study also found that small business lending (volume of loan amounts under $1 million) has barely recovered since 2012, and now stands at a level 17 percent below the pre-recession peak.

Why have banks been quicker to issue big business loans? Simply put: it’s often more profitable for banks to make big loans than it is to make small loans. According to a Harvard Business School working paper by Karen Mills, former head of the U.S. Small Business Administration, the transaction costs for a bank to issue and process a $100,000 loan are not much less than the costs of issuing a $1 million loan. So as a result, “Some banks, particularly larger banks, have significantly reduced or eliminated loans below a certain threshold, typically $100,000 or $250,000, or simply will not lend to small businesses with revenue of less than $2 million, as a way to limit time-consuming applications from small businesses.”

This can be frustrating for small business owners who “only” want to borrow $100,000 or less – but this and other structural barriers to traditional bank lending are unlikely to go away. Unfortunately, this type of bank lending environment is likely to be the “new normal” for small businesses.

More Companies are Getting Loans from Alternative Lenders

In response to the lending limitations of traditional banks, small business owners and entrepreneurs are doing what they do best: innovating. Instead of being denied their dreams or scaling back their business plans, small business owners are borrowing money from alternative lenders – including online platforms like Kabbage, peer-to-peer funding sites, or online marketplaces.

According to a recent CNBC article, “Why Small Businesses Don’t Want a Loan,” the size of the U.S. nonbank financial system is now estimated to be $3.2 trillion, with plenty of growth potential. Jef Stibel, CEO of Dun & Bradstreet Credibility Corp., was quoted as saying, “Alternative lending is a big deal and it’s becoming an even bigger deal for the smallest businesses with revenues under $5 million.”

Stibel also pointed out that according to Dun & Bradstreet’s Private Capital Access (PCA) Index, small businesses are significantly more likely than larger companies to use online marketplaces to get financing. During the first quarter of 2015, 3.4 percent of businesses with $5 million or less in revenue attempted to raise financing via an online marketplace, compared with only 2 percent of companies that had between $5 million and $100 million in revenue. Clearly the time is right for new innovations in small business lending, and small business owners are ready to think differently about where to get the financing that their companies need.

New Technology is Making Small Business Loans Faster and Easier

Traditional bank lending was often a predictable, rather stodgy affair: you go to the bank, you wait in line, you sit in the office with a banker wearing a nice suit, you fill out applications and paperwork (on actual “paper”)…it’s all very formal, old-fashioned, and “pre-digital.” The new alternative lenders and online marketplaces are putting a fresh face on the small business lending process by bringing a dose of much-needed innovation to the lending process.

New technology is making small business loans easier, faster, and more convenient. According to Fortune, “Tech’s Next Disruption? Small Business Loans,” alternative lenders are using technology to beat the big banks at the small business lending game. Instead of getting denied access to credit by big banks that aren’t interested in lending less than $100,000, small business owners can go online and quickly get approved for short-term loans at rates that are competitive with a traditional bank and often much cheaper than credit card interest rates.

Although alternative lenders make up a small percentage of the small business lending market – only $10 billion out of $600 billion – they are changing the loan landscape by making it possible for small businesses to get approved for loans that big banks might never have bothered with.

The “old days” of sitting in a bank lobby waiting to get approved for a small business loan might be gone for good – but that’s not a bad thing! Even if big banks never resume lending at the same levels as they did before the recession, there are now a variety of encouraging alternatives on the market. And hopefully these new types of small business loans will unleash a wide variety of innovations and new jobs. Only time will tell.